Maintaining the right mix of debt and equity to finance the business and its growth has always been a duty of company owners and financial executives. However, given the challenging mixture of interest rate swings, inflationary pressures and emerging opportunities in our current economy, making sound decisions related to capital structure has become more important than ever.
Companies want to maximize enterprise value, and the engine that drives that effort is capital structure. Here are five recommendations for keeping your company’s capital structure tuned up and purring like a kitten in today’s volatile and uncertain economic environment:
1. Realistically assess your cash flow prospects.
The capital structure must support the business strategy, and that strategy is based on your assessment of the company’s opportunities, including how much revenue they will produce and how fast. Overly optimistic projections can result in a capital structure designed to raise capital too aggressively. If your forecasts don’t pan out, it can become a challenge to meet debt service payments, costing you the flexibility to pursue new growth paths.
2. Make sure the capital structure supports the business based on where it’s at in its life cycle.
The appropriate capital structure for a newly launched company is very different from the structure that’s appropriate for a company in its growth or mature stages. You may start your business with funding from friends and family. Then, as your business finds its footing and revenues rise, opportunities may emerge to partner with equity providers such as venture capitalists, angel investors and private placement investors.
As a company grows, and cash flows become steady and predictable, debt alternatives emerge. At this stage, bank lending options may include revolving lines of credit to finance working capital and term loans to fund long-term assets like buildings and equipment. Some companies with healthy accounts receivable and/or inventory may turn to asset-based lending. Businesses willing to take on higher interest rate debt can consider mezzanine financing and junior capital.
Mature companies have many more options. The point is there are appropriate debt and equity strategies to consider depending on where the company is at in its life cycle.
3. Understand the tradeoffs between debt and equity.
Every decision about capital structure has a tradeoff. At the most basic level, there is a tradeoff whenever you choose between debt and equity capital. Debt on the balance sheet imposes financial discipline, while equity tends to allow for greater flexibility but often at a higher cost.
The financial discipline that comes with the need to service debt can keep a company focused on its mission and help it avoid getting sidetracked. On the other hand, the flexibility afforded by equity capital frees you up to pursue more opportunities and can accelerate growth. In addition, from an estate planning perspective, less debt can mean fewer covenants and more flexibility when transferring business ownership to the next generation (e.g., through a trust).
Understanding the tradeoffs you make when formulating the capital structure is vital.
4. Partner with the right capital providers.
One of the most important considerations as your company moves through its various stages of development — and more and more capital providers start knocking on your door — is choosing the right providers. Ideally, you want ones that:
▪ Demonstrate a history of stable relationships with companies over long periods of time.
▪ Offer consultative value based on knowledge of your business segment and products.
▪ Believe in your business and are willing to support you through tough times.
It’s easy to choose the provider offering to write the biggest check, take the least amount of equity in your business, or provide the cheapest debt. Don’t do it. Consider factors beyond the terms of the deal.
5. As your company matures, focus on cost of capital.
Your capital structure strategy should evolve as your company matures and achieves steady revenue growth. For instance, you should focus more on minimizing your blended cost of capital. At the mature stage of a company’s life cycle, owners can employ a variety of tax strategies associated with debt to bring that cost down.
To enhance your capital structure going forward, you want to be able to show potential future capital providers that the return on your business’s capital is exceeding its cost.
As the economy revives and new opportunities arise, by following these five recommendations you will be able to lean on your capital structure to support your business strategy, provide financial flexibility, and maximize the value of your company.
To further explore how Union Bank can assist with your strategic and capital structure needs, speak to your relationship manager or visit Union Bank to request an appointment with a relationship manager.
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